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Demise of Smartphone Contracts and its Effect in the US

iPhones, Samsung Galaxy and other premium smartphones were mostly offered under contracts by the carriers in the US. Recent developments have almost put an end to this. We analyze the impact of it on the US smartphone market.

iPhones, Samsung Galaxy and other premium smartphones were mostly offered under contracts by the carriers in the US. Recent developments have almost put an end to this. We analyze the impact of it on the US smartphone market.

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The American smartphone market has been relatively stable compared to India and China. Apple and Samsung have managed to hold on to the No.1 and No.2 positions in the US for quite a few years now. A big part of this has been possible because of contracts, amongst various other factors.

The Contract Mafia

Contracts were in some ways a cornerstone of the US telecom market, something which defined them. In a contract system, smartphone buyers would generally make a nominal initial payment depending upon the brand and internal storage of the smartphone. Under a contract, users would then have to remain with the carrier for typically two years and terminating the contract before that would lead to an early termination fee. Carriers recovered the cost of the device’s original value by charging higher service fee for the duration of the contract, just because the initial upfront payment was low, it didn’t mean carriers took a hit on their profits.

Contracts brought several benefits with it. For one, it gave carriers a predictable revenue path and secondly it helped consumers buy expensive smartphones by just paying fraction of the price upfront. A lesser spoken about benefit of contracts had been that it gave the initial smartphone industry a huge boost as contracts hid the true price of a smartphone upfront and recovered the price in the form of increased bills every month. However contracts had its fair share of down sides as well.

Contracts had made it highly necessary for smartphone manufacturers to play nice with telecom operators since telecom operators got to decide which smartphones they would offer under contract. This meant several smartphones would be pre-loaded with several carrier branded apps that’s often termed as “bloatware”. This meant that carriers now had the right to slap their own logo on the smartphone. Android smartphones were perhaps the worst affected by it. Also, since carriers were and still are the most dominant point of sale, in case a manufacturer didn’t play well with carriers, their fate in US was essentially sealed. The best example of this was Sony.

The arrival of contracts also made it almost mandatory for consumers to upgrade to a newer smartphone every time their contract came to an end, which was generally two years. In case a user didn’t upgrade to a newer smartphone at the end of their contract period, they would essentially be overpaying for their smartphones.

Contracts also made it easier for high end smartphone manufacturers as devices that retailed for $600-$700 unlocked could be bought under contracts for just $200-$300 depending on the internal storage of the smartphone which meant a price difference of ~$400. While at the same time, contracts had put manufacturers of mid/low end smartphones at a disadvantage. For example, if a mid range smartphone’s unlocked price was just $300 it would be offered under contract for $100 which meant a price difference of just $200. A high end smartphone with much better specs was offered for just $200 under a contract while a mid range smartphone was $100 with much lower specs and overall appeal. The $100 difference in price tag wasn’t worth the difference in user experience, especially since the monthly bill after the upfront payment would remain the same for both high end and mid range/low end smartphones. This led to a scenario where iPhones and high end smartphones from Android manufacturers like Samsung, LG, HTC and Motorola ruled the roost.

It’s changing now

However, starting with 2013, telecom carrier T-Mobile made a very bold move. The company abandoned contracts altogether and went for an equipment installment (EIP) only plan. The move worked for T-Mobile so well that soon enough all other carriers had their own verison of EIP as well.

In an EIP, the device’s cost is paid by the user over a particular time period. So for example if someone buys a $240 mid range smartphone they can pay $10/month for 24 months, and similarly if a user buys a $720 high end smartphone they can pay $30/month for 24 months. Different carriers provide a variety of time-period to pay for a smartphone.

Also, in this case, the end user has a choice to hang onto a device after paying for it and the device’s cost is separated from service fee. So for example, if by now I have paid for my iPhone 6 fully in EIP and don’t feel the need to upgrade, I could just pay the service fee alone. By contrast, in a contract, the device and service fee would be clubbed together. So once a contract’s period was over, users would be eligible to upgrade, in case a user didn’t upgrade, the device fee wouldn’t be deducted and the user would actually be overpaying for the device.

T-Mobile’s move to EIP was so popular that not only did other carriers follow them, and brought out their own EIP, but they also started to stop offering contracts one by one. AT&T said that it could stop offering contracts at certain locations. Verizon, then in a surprise announcement, said that even it would stop offering contracts for all new subscribers. Even Sprint has recently announced that it would stop offering contracts. With that, all four major carriers in America have now decided to stop offering contracts.

Effects of demise of smartphone contracts

1. Level playing field

The end of contracts will finally make it possible for mid range and low end device makers to have a fair playing ground in US. As explained earlier, under a contract system, a $600 unlocked smartphone would be offered for $200 and a $300 unlocked smartphone for $100. So even though the actual price difference is $300, under contract that price difference diminishes to $100. This made the value proposition of high end devices better under contract compared to mid range or low end devices. The direct beneficiary of these would be Hauwei and ZTE that make low end/mid range devices. In fact, Huawei just signaled at CES 2016 that it would be bringing its Honor line of devices in US.

2. No mandatory update

Under contracts, after two years or whenever the contract ended, users used to have a chance to upgarde to a newer device by paying $200 or so and renew their contract. In case someone didn’t renew their contract, they wouldn’t get a new device and their monthly fee would remain unchanged, so they would end up overpaying.

In case of EIP, once a person ends up paying for his smartphone, his bill would be reduced to just the normal service fee that’s charged. It would then be fully up to the person as to whether he wants to upgrade to a newer device or stick with his current device for longer.

3. No lock in

Under a contract, if in the middle, a user wanted to shift between carriers, a hefty early termination fee was levied upon them. This made several people stuck with their carriers at least until their contract ended. In case of EIP, users can pay for the complete device at any point of time and shift carriers to their liking.

Fall of Apple and Samsung?

Even though contracts have ended, the claim that Apple and Samsung will fall from their positions seems unlikely. There are several reasons for this

1. Leasing plans

Recently, both Sprint and T-Mobile have brought about leasing plans. Under a leasing plan, a user can lease an iPhone or a high end smartphone for as low as $1 per month. Leasing plans also have built in upgrades that require a user to turn in their iPhone or Android smartphone after a period of time, say one year, and then upgrade to the newer version of iPhone or Android smartphone at the same leasing rate. The iPhone or Android smartphone that’s returned is refurbished and sold again.

There’s a fun fact in this. Although it’s widely believed that contracts “subsidized” the price of high end smartphones, they never really did that – rather the upfront cost to be paid was reduced and the entire cost was recovered in the form of higher monthly fees. In case of a leasing program, the device’s cost is truly subsidized. Although it can be argued that EIP have finally made the playing field equal for mid range and low end smartphone manufacturers, leasing plans from at least Sprint and T-Mobile provide an option to have the latest iPhone or Galaxy and not have to pay the full price. This to some extent spills away the concern that people would stop buying the latest iPhone or Galaxy because at least Sprint and T-Mobile through their “iPhone forever” and “Jump ON demand” programs provide a cheap way to have them and in case it becomes popular, AT&T and Verizon will surely follow them just as they did with the abolishment of contracts.

2. Promotions

The US smartphone market requires a lot of marketing in order to be successful. In fact, a lot of Samsung’s success in overtaking HTC is directly linked to how the former was much better than HTC in marketing its products. Super Bowl ads can cost millions, and Samsung and Apple spend millions every year in marketing their products and creating a brand name. It remains to be seen if manufacturers of low end and mid range products such as Huawei and ZTE can match such marketing budgets. Huawei and ZTE are already banned in America from supplying equipments to telecom operators, and being Chinese, they need to invest much more on marketing, if they are to change how people think about them.

3. Patents

Patents are yet another issue in the American smartphone market, Samsung’s meteoric growth in US came at a cost and that cost was being sued by Apple quite a lot of times. Needless to say, in case some manufacturer like Xiaomi or someone else starts gaining meaningful traction in America, Apple would easily file a lawsuit against them given how much their UI and designs mimic iOS and iPhones.

4. Manufacture upgrade program

Following the demise of contracts, along with the launch of iPhone 6S, Apple announced the iPhone upgrade program. Under this, a user could buy a new iPhone 6S and make monthly payment to Apple. It is very similar to carrier’s leasing plans and under the this, users could return their iPhone 6s and upgrade to the iPhone 7 as soon as it launches. Along with the upgrade, users will also get Apple care for free which further sweetens the overall deal. Samsung is also rumored to follow up with its own upgrade program.

5. Apple least likely to be affected

Even if there is to be an effect from the shift to EIP, Samsung seems most likely to be affected by it. Apple owing to the exclusive software (iOS), hardware (A9) and services (Facetime) is least likely to be affected. Since Samsung is competing in what has essentially become a commodity market, if there is a race to bottom, Samsung will be the worst effected by it. In Samsung’s defence it must be noted that the company does release several mid range and low end smartphone across the world. If the threat does become real, Samsung can start launching those models in US as well, whereas Apple doesn’t have this kind of a fallback.